Looking Beyond Past Performance in Manager Selection

Many retirement plan sponsors and other institutional
investors feel they are being thorough in looking back as far as five years
both in selecting new investment managers and making termination decisions (see “Process
for Terminating Investment Managers is Important”). However, even five-year
performance can be a poor indicator of future success, according to Segal
Rogerscasey, mainly due to a decided lack of long-term performance persistence
within nearly all investment classes.

To determine whether past performance is indicative of
future results, the firm examined 12 peer groups of investment managers across
a variety of active equity and fixed-income styles. Managers were ranked into
quartiles for each peer group based on investing performance from January 1,
2004, to December 31, 2008. Next, the performance of top- and bottom-quartile
managers from this first period was analyzed for the subsequent five-year
period running January 1, 2009, to December 31, 2013.

As explained by Segal Rogerscasey, performance persistence
in this analysis was “generously defined” as when more than 50% of a peer
group’s top-quartile managers from the five-year period starting in 2004 also
finished in the top half of active managers for the five-year period starting
in 2008. Drawing this hard line gives “somewhat more significance than is
merited” to the peer groups that finished close to the 50% threshold,”
researchers explain, but the overall results still hold.

The
results of this analysis were particularly striking among the three
fixed-income peer groups, Segal Rogerscasey says. The vast majority of
fixed-income managers that led their peer groups during the 2004 to 2008 period
fell into the third or fourth performance quartile during the following five
years. Managers of high-yield fixed income had the greatest level of
performance persistence among the three fixed-income peer groups, at 32%. This
means just 32% of the high-yield managers who finished in the top quartile for
2004 to 2008 finished in either of the top two performance quartiles from 2009
to 2013.

The performance inconsistency was the most extreme for U.S.
core plus fixed-income managers, who invest in a core bond portfolio with
additional allocations to non-core assets, such as high-yield or emerging
market debt. Nearly eight in 10 (77%) members of this peer group who finished
in the first quartile between 2004 and 2008 fell into the bottom two quartiles
for the period 2009 to 2013, according to Segal Rogerscasey. Conversely, 91% of
the fourth-quartile managers in this peer group in period one (2004 to 2008)
rose to the first or second quartiles in the following five-year period.

Another interesting upshot of the research is that this
year’s findings about fixed-income peer group performance persistence are
significantly different from figures covering five-year periods from 2003 to
2007 and 2008 to 2012—largely because of the lasting impact of the 2008
financial crisis on five-year investment manager return measures. Massive
market corrections often have a confounding impact on medium-term performance
review efforts, researchers explain, further challenging retirement plan
fiduciaries to make sound backward-based predictions of future performance.

Results among the nine equity manager peer groups analyzed
by Segal Rogerscasey also support the thesis that outperformance is rarely
persistent. In fact, emerging market equity was the only equity peer group
analyzed to show performance persistence during the most recent 10-year period,
something researchers explain as an essentially random result. Strikingly,
among U.S. small cap equity managers of every style, an investor had a much
better chance of ending up with a first- or second-quartile manager in the 2009
to 2013 period by selecting from the fourth-quartile managers versus those who
finished in the top three quartiles from 2004 to 2008.

In
an attempt to identify any patterns in the performance data, researchers looked
at the behaviors of the 12% of U.S. large cap core equity managers who finished
in the first quartile for both 2004 to 2008 and 2009 to 2013. The only pattern
identified was that managers that protected assets better in the down market of
2008 (i.e., whose portfolios fell less than the Russell 1000 in that year) had
a higher likelihood of showing performance persistence in the 2009 to 2013
period of the study. Other than that, there was no discernible trend or
investing behavior, such as style tilts, that might help one predict which
top-quartile managers would manage to outperform in both five-year periods.

One of the more counterintuitive results of the analysis,
according to Segal Rogerscasey, is the lack of performance persistence in
capacity-constrained sub-asset classes, such as U.S. small-cap core, growth and
value, or emerging markets equity. Some may assume that stocks in these areas
are less closely followed by sell-side analysts and thus perhaps offer more
scope for an informational or tactical advantage among skilled active asset
managers.

This may be true to some extent, researchers say, as about
77% of emerging market equity managers have outperformed the MSCI Emerging
Markets Index during the 10-year period ending December 31, 2013. However, this
insight does little to help one to identify which active manager among a group
of peers will perform best, or indeed which ones will even be able to beat
their benchmarks.

One explanation for the inability of first-quartile active
managers to maintain outperformance relevant to peers may be that a manager
with a strong five-year track record is likely to attract large amounts of new
investments. A major inflow in strategy assets may limit the manager’s ability
to nimbly trade less-liquid assets, which may dampen performance. As stressed
by Segal Rogerscasey, this type of research is highly end-point dependent. So
in last year’s version of the study, which reviewed different five-year
periods, results for each peer group differed substantially.

Given all this, Segal Rogerscasey recommends that investors
(and retirement plan fiduciaries) should rely on a forward-looking approach
based on fundamental research when selecting active managers. Such fundamental
research involves plan fiduciaries closely examining the investment manager’s
stated strategies and processes, Segal Rogerscasey says. It’s also important to
review credentials and regulatory background for any issues.

In this scenario, past performance is only used as a
validation of a manager’s capabilities, researchers explain. When the plan fiduciaries
do look at past performance, they should be sure to look across various market
cycles to see how the manager performs in different macroeconomic conditions.